Human Resource & Payroll Services And Solutions - Houston, Dallas, Austin - Texas www.hrp.net. Affirming a decision in the lower court, the Sixth Circuit Court of Appeals ruled recently in a controversial case that severance payments made to employees are exempt from federal payroll taxes.

1. Toll Free: 877.880.4477
Phone: 281.880.6525
Employee Payroll Spotlight:
Are Severance Payments Subject to Payroll Taxes?
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2. » Affirming a decision in the lower court, the Sixth Circuit Court of Appeals
ruled recently in a controversial case that severance payments made to
employees are exempt from federal payroll taxes. (U.S. v. Quality Stores,
Inc., CA-6, No. 10-1563, 9/7/12)
» As a result, the government must refund over $1 million in payroll taxes
that were improperly collected from the employer and employees.
Payroll Taxes
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3. » In the wake of this case, an employer may want to file a protective refund
claim for open tax years if it previously paid the full amount of payroll
taxes on severance payments. (There is a statute of limitations on filing.)
» Nevertheless, don't expect the IRS to throw in the towel on this issue. Due
to conflicting decisions in other courts, the IRS is likely to appeal this
latest decision.
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4. Basic Tax Rules
» For 2012, an employee must pay a 4.2 percent OASDI tax on the amount
of wages up to the "Social Security wage base" of $110,100 and a 1.45
percent Medicare tax on all wages. The employer must also pay its
corresponding share of these payroll taxes.
» Beginning in 2013, the 4.2 percent OASDI tax rate will revert to a 6.2
percent rate, barring any extension of this tax provision by Congress. This
was the rate in effect prior to a one-year tax break initially enacted for
2011 only and subsequently extended through 2012.
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5. In general, wages that are subject to income tax withholding are also
treated as wages for payroll tax purposes. However, certain types of
payments to employees are excluded from the definition of "wages" for
federal income tax purposes, including Supplemental Unemployment
Compensation Benefits (SUB). To qualify as SUB, payment must be:
1
1 Made to an employee;
2
2 Pursuant to an employer's plan;
3
3 Due to an employee's involuntary separation from employment, whether
temporary or permanent;
4
4 Resulting directly from a reduction in force, the discontinuance of a plant
or operation, or other similar conditions; and
5
5 Included in the employee's gross income.
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6. » Because severance payments are clearly wages for federal income tax
purposes, the IRS has consistently maintained that any severance
payments made to terminated workers are subject to payroll taxes.
» Traditionally, the courts have gone along with this point of view. But now,
the Quality Stores case turns things upside down.
Payroll Taxes
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7. Facts of the Recent Case
» Quality Stores was the largest agricultural-specialty retailer in the country
serving farmers, hobby gardeners, skilled trade persons, and do-it-
yourself customers.
» The retail chain encountered financial difficulties and closed 63 stores and
nine distribution centers. It also terminated the employment of
approximately 75 employees at its corporate offices.
» In 2001, an involuntary Chapter 11 bankruptcy petition was filed against
the retail outfit. Quality Stores then closed more than 300 stores and its
remaining distribution centers. Finally, it discharged all the employees
who were still left on the payroll.
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8. » The terminated employees received severance in amounts based on their
job grade, management level, time on the job and their date of
termination.
» Initially, Quality Stores reported the severance payments as wages on
employees' W-2s, withheld the appropriate amount of income taxes and
payroll taxes, and paid its share of the payroll taxes. However, in 2002, it filed
refund claims for overpaid payroll taxes totaling $1.125 million, plus interest,
on the severance payments.
» The District Court in Michigan ruled the severance payments should not be
characterized as wages for payroll tax purposes. It said that the payments
were in the nature of SUB payments.
» The District Court also referenced a landmark Supreme Court case (Rowan
Companies, Inc., 452 US 247, 1981) in its decision.
» In the Rowan case, the Supreme Court determined that Congress intended a
uniform definition of "wages" for income tax and payroll tax purposes.
Subsequently, Congress passed a "decoupling rule" separating the imposition
of payroll taxes from the treatment of income taxes in existing regulations.
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9. » Now the Sixth Circuit Court of Appeals has sided with the District Court. It
found that Congress has expressly provided that any payment that meets
the statutory definition of a SUB payment is treated as if it were a
payment of wages.
» According to the court, Congress did not consider SUB payments to be
wages, but allowed their treatment as wages in order to facilitate federal
income tax withholding.
» Because SUB payments are not wages, but are treated as if they were
wages for federal income tax withholding, SUB payments are also not
wages for payroll tax purposes.
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10. » The court also rejected the IRS claim that the Rowan case is no longer
controlling. When Congress enacted the decoupling rule, it did not
provide that wages must be treated differently for purposes of federal
income tax withholding and payroll taxes.
» Instead, the amendment was intended to allow the IRS to issue
regulations to provide for different exclusions from wages under FICA
than under the income tax withholding laws. The IRS has not issued any
regulations under the decoupling amendment.
» The Sixth Circuit Court said the
payments were SUB payments
that aren't subject to payroll
taxes. It is noteworthy that this
new decision conflicts with
another Federal Court of Claims
decision (CSX Corp. v. U.S., CA- FC,
101 AFTR2d 2008-1120) made in
2008.
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11. Lessons to Be Learned
» As evidenced by the new case, the money involved can be substantial.
Even if your small company doesn't have millions at stake, you might save
tens or even hundreds of thousands of tax dollars based on the latest
ruling.
» Be aware that the IRS hasn't conceded defeat on this issue and the case
may eventually work its way up to the U.S. Supreme Court. In the
meantime, an employer in similar circumstances may want to file
a protective claim to preserve the statute of limitations on payroll tax
refund claims for open years and later file a supplementary claim with the
requisite employee consents and calculations.
» The due date for making a protective claim is three years from April 15 of
the year following the year in which the severance payments were made.
For example, if payroll taxes were paid in 2009, the protective claim
should be filed by April 15, 2013.
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12. Until this matter is completely resolved, employers are generally advised to
continue withholding FICA taxes on separation payments made in
connection with the an involuntary termination of employees.
Consult with your tax adviser or attorney about your situation.
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